Europe plans for debt doomsday scenario

Larry Elliott, Heather Stewart, Ian Traynor February 17, 2012

CENTRAL banks across Europe have a collective nightmare. It is of the day Greece defaults on its debts, and the Aegean Sea is awash with small boats in which fleeing Greeks huddle with suitcases full of euros. Guards patrol the border in an attempt to prevent the flight of capital. Things get ugly and there are shootings, captured on film. Despite the best efforts of policymakers in Athens, Brussels and Frankfurt, it proves impossible to contain the panic, which spreads to Portugal and Ireland, the other two countries going through tough austerity programs in return for bailouts from the European Union and the International Monetary Fund.

Across Europe, governments are engaged in contingency planning for this sort of scenario. In Britain - which had first-hand experience of how crises can escalate when there was a three-day run on the Northern Rock bank in 2007 - the Bank of England, the Treasury and the Financial Services Authority have been ''war-gaming'' what might be expected in the event of Greece repudiating its debts and leaving the single currency.

Big businesses have also made preparations for a euro meltdown, fearful not just of the direct impact on sales but of a drying up of credit and trade finance. Few doubt that a messy Greek default would lead to a credit crunch at least equal in severity to that which followed the collapse of Lehman Brothers in September 2008.

Policymakers have stepped up the pace of their planning following the marked deterioration in the relationship between Greece and its single-currency partners. Athens believes the rest of the euro zone wants Greece out, while Germany is leading the group of hardline countries demanding assurances before the €130 billion ($158 billion) bailout is agreed.

While Germany's Finance Minister, Wolfgang Schauble, says ''we're better prepared than two years ago'', others believe the ramifications of a Greek exit would be felt globally. ''The consequences would be devastating for Greek citizens and particularly for the most vulnerable,'' Amadeu Altafaj Tardio, spokesman for Europe's commissioner for economic and financial affairs, Olli Rehn, said. ''Consequences would be felt throughout the euro zone and beyond.''

European policymakers are also looking to the possibility of the country crashing out of the euro. Greece would probably have to impose capital controls - limits on the amount of money that can be taken in and out of the country - while it implemented ''drachmatisation''. All balances at Greek banks would probably be redenominated at a fixed exchange rate with the new (or rather the old) currency; but banks could be shut, or strict limits placed on withdrawals from cash machines, while the details were worked out.

In the worst-case scenario, Greece could be followed by more countries as markets speculated on whether Portugal, Ireland or Spain would be next to default.

It is to forestall a Greek domino effect that the European Central Bank has flooded the continent's banks with cheap money over the past two months. Brussels believes the replacement of Silvio Berlusconi as Italian prime minister by Mario Monti has helped create a firewall between Greece and its southern European neighbours. The containment strategy has worked until now, but may be about to face its biggest test.

Guardian News & Media